Financial Daily

from THE HINDU group of publications

Monday, November 12, 2001

Documentary letters of credit

V. Krishnamurthy

A DOCUMENTARY credit is frequently the agreed method of settlement for

international trade. The buyer's bank reimburses the seller against
presentation of documents drawn in compliance with conditions stipulated
in the documentary credit by the buyer.

There are advantages to both the buyer and seller when settlement is
arranged by documentary letter of credit. First, the buyer knows that
payment will only be made if the documents received comply strictly with
the terms and conditions of the credit as stipulated by the buyer. Second,
the seller knows that payment will be received provided the terms and
conditions of the credit are strictly complied with.

Documentary letter of credit

A documentary credit can be defined as a conditional undertaking of

payment given by a bank. Expressed more fully, it is a written conditional
undertaking issued on behalf of the importer (applicant) by the issuing
bank to the exporter of goods (beneficiary) to pay for the goods or
services, provided the documents submitted conform strictly to terms and
conditions of the credit.

From this definition it can be seen that there are basically three parties to
a documentary credit: a) the buyer/importer, who requires that a credit be
issued in his favour; b) the beneficiary (the supplier of goods); and c) the
issuing bank which issue s the credit at the request of the buyer or
importer. The credit is usually (but not always) advised to the beneficiary
through a bank in the beneficiary's country (the advising bank).

All documentary letters of credit are subject to the provisions of Uniform

Customs and Practices (UCP) for Documentary Credits, Brochure No. 500
issued by International Chamber of Commerce, wherever it is incorporated
into the text of the credit as such.

Types of credit

There are various types of documentary credits. A revocable credit is one,

which can be amended or cancelled at any time without prior notice or
warning to the seller (Art. 8(a) UCP 500). It involves risks to the
beneficiary, as the credit may be amended or cancelled while the goods
are in transit and before correct documents are presented. The seller of
goods would then face the problem of obtaining payment directly from the
buyer.

A revocable credit gives the buyer maximum flexibility, as it can be

amended or cancelled without prior notice to the seller up to the moment
of presentation of documents to the bank at which the issuing bank has
made the credit available for payment.

An irrevocable credit cannot be amended or cancelled without the

agreement of the issuing bank, the confirming bank (if the credit is
confirmed) and the seller (beneficiary). An irrevocable credit gives the
seller greater comfort of payment but is really only dependent upon the
undertaking of a bank abroad. The buyer can request the advising bank to
add its confirmation to an irrevocable credit if he is not satisfied with the
assurance of the credit-issuing bank. If the advising bank agrees, the
irrevocable credit becomes a confirmed irrevocable credit. For adding
confirmation, the bank will charge commission, which may have to be paid
by seller.

A confirmed irrevocable credit gives the seller a double assurance of

payment, since a bank in the seller's country has now added its own
undertaking in addition to that of the issuing bank to pay for the
documents drawn under the letter of credit, provided of course, the
documents are drawn strictly in compliance with the terms of the credit.

Transferable credits

A transferable credit under Article 48 of the UCP is one under which the
beneficiary has the right to give instructions to the bank which is
authorised by the credit-issuing bank to effect payment, accept drafts or
negotiate documents to make the credit available in whole or in part to
one or more parties.

A letter of credit can be transferred only if it is expressly designated as

transferable by the issuing bank and can be transferred once only
(however, if part shipments are not prohibited, fractions of a transferable
credit may be transferred to more than one beneficiary).

When a credit is transferred to a second beneficiary or a number of

second beneficiaries, it must be transferred on the terms and conditions
specified in the original credit, except that: a) the amount of the credit
may be reduced, b) any unit price may be reduced, c) the validity may be
curtailed, d) the specified period of time after the date of shipment for
presentation of documents may be curtailed, e) the latest shipment date
may be curtailed, f) the name of the first beneficiary can be substituted ,
g) insurance cover percentage may be increased in such a way as to
provide the amount of cover stipulated in the original credit, h) the first
beneficiary may request that payment or negotiation be effected at the
place to which the credit has been transferred, up to and including the
original expiry date.

Back-to-back credits

#Two types of credit, by their very nature, cause bankers considerable

trouble and thought. They are back-to-back and transferable credits.

A back-to-back credit can be described as credit and counter-credit. It is a

method of financing both sides of a transaction in which a middleman
buys goods from one customer and sells them to another, both
settlements being made under documentary credit s.

When the documents are received under back-to-back credit by the bank,
they will advise the opener of the receipt of documents under the back-to-
back credit. The opener substitutes his own invoices and drafts made out
in the name of the foreign buyer and tenders the documents for
negotiation under the export letter of credit. The bank will then negotiate
both the documents and honour the documents submitted under back-to-
back credit from the proceeds of the original export credit. The difference,
if any , between the amount paid under the back-to-back credit and
amount reimbursed from the foreign bank under the export credit will be
paid to the original beneficiary, less bank charges.

Revolving credits

Revolving credits are those which renew themselves automatically. If the

renewal is not automatic but subject to reinstatement instructions, the
credit is not, in a true sense, a revolving credit in international usage. It is
rather a credit of fixed amount, which has to be increased by means of
amendment instructions after each drawing or, alternatively, a credit of a
fixed total amount is payable by specific instalments.

Under a revolving credit, the drawings made under the credit can be re-
available to the beneficiary, upon receipt of instructions from the opening
bank to the effect that the amount has been reinstated in the credit. A
credit can be made revolving as to time or up to a maximum amount of
drawing.

Red-clause credits

The object of the inclusion of the red clause in a documentary credit is to

enable the beneficiary to obtain pre-finance from a bank in his country. It
is called so because, historically, it was usually printed in red on the
advice of credit.

The red clause in the credit enables him to borrow money from the bank
to pay for the goods to be shipped. The beneficiary thus purchases the
goods and effects the shipments. After shipments are made, the
documents are tendered to the bank. However, the bank making payment
under the red-clause credit will be reimbursed by the opening bank
immediately on effecting payment to beneficiary.

There are two types of red-clause credits. One is secured and other,
unsecured. Under unsecured credit, the payment in advance will be made
to the beneficiary against presentation of clean drafts only, drawn on the
advising bank/opening bank. Under secured or documentary red-clause
credit, the advance will be made against warehouse receipts or similar
documents and the beneficiary's undertaking to deliver the relative Bills of
Lading upon shipment.

A green-clause credit is one which envisages the granting of storage

facilities at the port in addition to the pre-shipment payment to the
beneficiary. A standby letter of credit, while possessing all the elements
of a documentary credit subject to UCP, i s often used in lieu of
performance guarantee. Basically, the standby credit is intended to cover
a non-performance (default) situation, as with the traditional documentary
credit. The bank authorised to make payment under a standby letter of
credit will affect payment on presentation of requisite documents called
for in the credit to the beneficiary, although the opener may claim
performance.

Credits are available for settlement by acceptance/ negotiation

payment/deferred payment. The negotiation under a confirmed credit is
without recourse while one under an unconfirmed credit is with recourse
to drawer unless specified otherwise. Typically, a letter of credit nominated
in any other currency other than that of the beneficiary will be available
by `negotiation'.

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